By Tiernan Ray

Shares of Microsoft (MSFT) are down $1.34, or 4.4%, at $28.94, following last night’s reports by IDC and Gartner that PC sales in Q1 slipped either 14% or 11%, depending on which you believe, which IDC said was the worst drop since it began counting numbers in 1994, and Gartner said was the worst absolute tally for PCs since Q2 of 2009.

The stock got two downgrades this morning, from Nomura Equity Research’s Rick Sherlund, and from Goldman Sachs’s Heather Bellini.

Bellini cut her rating to Sell from Neutral, while maintaining a $27 price target, writing that PCs are shrinking as an overall percentage of the combined, or converged, “PC + Tablets” market:

The GS hardware team is expecting PC market share to decline from 73% in 2012 to 65% in 2013 and 59% in 2014. A more bearish PC outlook for 2013 is supported by IDC’s preliminary March 2013 quarter PC shipment data which reflects a 14% yoy decline and in our view suggests the secular headwinds for Windows appear to be continuing.

Bellini explores four “Plan B” options, as she calls them. One is a break up of the company, which she deems unlikely, as it erases “the synergies across Microsoft’s business groups.”

Another is to “leverage” some of the expected $32 billion of cash from operations it may generate this year, to fund further buybacks and dividends, and perhaps use more of its overseas cash. Every $5 billion raised would add 5 cents to EPS, she estimates.

The company could also use subsidies or cut prices to boost consumer adoption of products, she opines.

“While in the near‐term a subsidy‐based strategy would be a drag on operating profits, it nonetheless could help Microsoft focus on the lifetime value of the customer by increasing share for Microsoft in the next generation compute ecosystems.”

Fourth, the company could pursue further cost-cutting:

Microsoft’s SG&A remains elevated versus other large technology companies and as such there is likely room to lower its SG&A as a percentage of revenue. With a level about 400bps ahead of Oracle’s we believe there is room to reduce this level, although unlikely to be able to narrow the gap all the way to achieve the $0.33 benefit if the percentage was brought in line with Oracle’s SG&A trends. R&D spend is likely to stay at current levels given the need to invest in tablets and smartphones, as well as faster growth in R&D spend expected by Samsung Electronics and Apple over the next two years.

Bellini’s assessment of all these options is that probably, very little is going to actually change:

While we believe these options are worthy of consideration, in the near term we would expect Microsoft to continue with its current strategy although we think they are likely to evaluate several of these options over the intermediate/long- term.

I spoke with Sherlund by telephone a short while ago regarding his note. He added some thoughts about how to look at the PC market in the back half of this year:

March was a pretty good month [for PCs] from our sources in Asia, in contrast to January and February, which were just so bad. It really takes your breath away, just how bad the quarter was in terms of PC demand. It makes you wonder what is the secular story here? You know you might get an upgrade cycle when [Intel‘s (INTC) next PC processor] Haswell comes out, and you get 10 hours of battery life, and you start to get $600 price points for PCs. I think you will start to see some pickup in demand for the half of us who are in a dual environment, still using PCs as well as phones and tablets. I think there will be a price and a battery life where you say, I’m compelled to do something. I’m just not sure what the core business is doing that we’re going to be upgrading from. What is the core PC growth that you will start getting the benefits to upgrade from. Are we just going to decline less. We had assumed that you could grow the market modestly with an upgrade cycle. But Q1 now means a lower base. You have easy comparisons over the year, so I suspect this is the trough, if March is shaping up as a better month.The stock is difficult because it’s been such a value stock for years now. We are wondering how could you unlock some value. I don’t know that we can lay it all on Windows 8 not being the right product. There isn’t a right product if you’re trying to bridge over the old and the new. Got to have the right hardware out there. The tablet capabilities are there for you to start tapping into. You don’t buy it as a tablet, you buy it as an ultrabook touch. If all you want is a tablet, you already have an [Apple (AAPL)] iPad. It’s more about an ultrabook touch. It’s nice that you’re giving them the tablet capabilities. There is an upgrade opporuntiity in the second half of the year. Is the price really $599 where people are compelled or does it have to be lower.

As regards the prospect of taking Microsoft private, Sherlund remarked, “I’d like to think you could make something happen, but the enterprise value is $200 billion. That’s a pretty big company.”

There are all kinds of possibilities, including splitting off Microsoft Office, which is a “huge annuity revenue stream.” That’s something that would be easier for Microsoft to engineer as a private company. Another would be to sell off the Bing search operations and just reap the cash flow that comes from it without the cost of operations.

But whether broken up, intact, private or public, one point Sherlund seems adamant on is that Microsoft Office is caught between being a handmaid to Windows and being allowed to roam free on other tablets and smartphones:

It’s all about Office. There’s so much they could do to sell Office, but Microsoft is focused on trying to sell the Windows. Office is Microsoft’s anchor. How do you compete with Google‘s (GOOG) Android? The hardware guys can produce commodity tablets in China. The lever for Microsoft is Office. But they should deliver office on alternative platforms as well. You would hurt Windows 8 traction, but where is your better revenue opportunity? There is going to be a point in time where Windows has to stand on its own because we are missing an opportunity for a big annuity revenue stream.People are learning Evernote and Dropbox. Microsoft should be pulling Skype and Yammer sales through Office.

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